Lesson of the Day

Managing your personal debt can be made easier. Here are our 6 golden rules ..............so that you can make your debt work for you

UK households owe an average of £7,900 on personal loans, overdrafts and credit cards and are mostly paying an interest rate of around 18% to 20% at any given time. Also, improvements in Internet technology have led to the rise of Payday lenders who typically charge interest rates of 400%. So is debt bad for you and how should you control your debt?

Debt can be looked at as Good debt, Affordable Debt and Bad debt. Before taking out a loan you should first understand the difference between Good, Affordable and Bad debt and then ensure you feel comfortable about repaying all that you owe.

Good debt

Most people would agree that borrowing for a home makes good sense. This is an obvious example of good debt. You would not be able to afford to buy your house without borrowing and you are borrowing to buy something which will have a greater value in the long term. Other examples of Good debt might be borrowing for an educational course which will lead to a better paid job, for home improvements which will increase the value of your home. So, Good Debt can be good for your finances but only if you make sure you don't borrow more than you can afford to pay back, and shop around for the best rates.

Affordable debt

It is much better to save for the things you want and buy them outright. This is the sensible financial advice, but in the real world, why should you wait when you can have them now? You can have them now but this comes with a risk to your finances.

Unlike Good debt, Affordable debt is where you take out a loan to obtain something where the value will go down rather than up in the future. You are therefore not borrowing to buy something of long term worth but to enjoy today what you will need to pay for tomorrow. As the name suggests, this is acceptable but only if you can afford to repay the loan and we would further suggest that you need to enjoy the benefit of your purchase for the period of the loan payments. Examples of Affordable debt would be taking out a loan for the purchase of a car where you aim to own and use the car after the loan has been repaid. A second example may be a sofa where you repay the debt over 2 years and you believe it will last for 5 years. Affordable debt, therefore, is acceptable, but only if you can afford to pay back the loan. There is also a further word of warning here - Affordable debt, needs to be carefully rationed. It is too easy to delude oneself that Loans are affordable and end up with a number of loans where not all the repayments can be made. This is a mistake made by many and leads to a downward spiral of debt. 

Bad debt

Bad Debt should always be avoided. Bad debt is where you borrow today for things that you consume today and that you will need to pay for tomorrow. The most obvious example of this is a Credit Card. A Credit Card should not be used to pay for anything that you cannot afford to pay for in two months. You should always aim to clear your monthly balance each month or in the worse case the following month. Use of a Credit card can be a great convenience but there is no quicker way to get into debt troubles if you cannot afford to pay off your monthly balance. Remember, interest rates of 18% and Store cards of 30% are common so this is therefore a very expensive way to borrow money. As a rule, never incur Bad debt and be wary of mounting Affordable debt, but how do you manage your debt. Below are our 6 Golden Rules for managing debt

6 Golden Rules

To manage your borrowings follow these rules:

1. Whenever you borrow, understand whether your debt is Good, Affordable or Bad. If it is Bad debt then show constraint and don’t borrow. Cut back if you do not want your debt to spiral out of control. It is the start of a slippery slope. If your debt is Affordable debt then be wary you are not on the path to having more debt than you can afford. Affordable debt mounts up very quickly and needs to be rationed.

2. Whatever the borrowing, make sure you can afford to comfortably repay the loan. As a generalisation, your monthly repayments on all you borrowings should not exceed 33% (one third) of you total monthly income. If it does you will struggle to make comfortable repayments.

3. Know what you spend your money on. Write down the things you spend money on each month and make cut back. Use the left over money to reduce your loans more quickly. See our “5 Tips for Savings” article

4. Pay off your highest interest rate loans first. It makes sense to reduce the balances of loans or credit cards that charge the most interest while just paying the minimum due on all your other debt. Once the high-interest debt is cleared, tackle the next highest, and so on.

5. Consider consolidation of your borrowings. This can help to reduce your monthly repayments by consolidating your loans and credit cards into one loan. Again, this action comes with a health warning – it will be of little benefit to you to consolidate your loans\Credit Cards if you do not control your spending. You will be simply building debt and end up in a worse situation than before.

6. Ask for help. If you have more debt than you can manage, get help before your debt breaks your back. There are reputable debt counselling agencies that may be able to consolidate your debt and assist you in better managing your finances. But there are also a lot of disreputable agencies out there

In conclusion

Debt is not a bad thing if you have borrowed for the right reason. You need to be honest with yourself about your reasons for borrowing and about your level of borrowing. If, as with many people, your borrowing has led to repayments with which you struggle, you should address the situation. There is no situation that cannot be addressed. The worse thing you can do is ignore debt and allow it to grow. If you can you should cut back your spending to make the due repayments but if this is not enough then approach your Lenders and agree repayments you can afford. Remember it is in their interest to help you repay your debt. If you are not comfortable at tackling your debt then seek help, and if you are really stuck then Calm money can help you. Simply use our Contact Us form and we will call to discuss your best way forward. The sooner you start the process the sooner a great weight is lifted off of your shoulders